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BREAK EVEN

ANALYSIS

Topic 1
Engr. Tafalla
November 30, 2015

Definition:
ENGINEERING ECONOMY is a discipline
concerned with the systematic evaluation of the costs
and benefits of the proposed business projects and
ventures. Its objective is to choose which among the
alternative course of action will give the maximum
benefit at the least cost.
Engineering Economy, therefore involves the
application of definite laws of Economics, theories of
investment and business practices to engineering
problems involving cost. It also involves the study of
cost features and other financial data and their
applications in the field of engineering as basis for
decision.

COST CONCEPTS
DEMAND is the quantity of a certain commodity that is bought at a certain
price at a given place and time.
SUPPLY is the quantity of a certain commodity that is offered for sale at a
certain price at a given place and time.
FIXED COST are costs that do not vary in proportion to the quantity of
output.
VARIABLE COST are costs that vary in proportion to quantity of output.
BREAK EVEN POINT is the level of production at which revenue is exactly
equal to total costs

Elements of Cost:
1)Materials
a) Direct Materials are those which are used in the
finished product itself.
b) Indirect Materials are those materials used in
production but which do not go into the finished
product.
2) Labor
a) Direct Labor is the actual work applied directly to
the manufacture of the product
b) Indirect Labor is the work necessary for the
operation of the factory, but which cannot be
identified with one particular process or product
manufactured.

3) Overhead Expenses
Expenses which cannot be allocated to direct
materials or direct labir.
PRIME COST = Direct Materials Cost + Direct Labor
Cost
PRODUCTION COST = Direct Materials Cost + Direct
Labor Cost + Overhead Cost
Or
PRODUCTION COST = Prime Cost + Overhead Cost

LAW OF SUPPLY
The supply of the commodity varies directly as the
price of the commodity, though not proportionately
p
r
i
c
e

Supply

LAW OF DEMAND
The demand for a commodity varies inversely as the
price of the commodity, though not proportionately
p
r
i
c
e

Demand

LAW OF DEMAND AND SUPPLY


Under conditions of perfect competition, the price at
which any given product will be supplied and purchased
is the price that will result in the supply and the demand
being equal.
p
r
i
c
e

Quantity

The relationship between price and demand can be


expressed as a line
p
r
i
c
e

p = a - bD

Demand (D)

Where a is the intercept on the price (p)axis and b is


the slope.

TOTAL REVENUE VOLUME


RELATIONSHIP
T
O
T
A
L

R
e
v
e
n
u
e

Peak point represents the


Maximum revenue

Demand that maximizes


Total Revenue

TR pD
TR (a bD) D
or
TR aD bD 2

D'

Volume (D)

COST - VOLUME RELATIONSHIP


Total Cost
C
o
s
t

TC TVC TFC
TC vcD TFC

Variable Cost
Fixed Cost

Volume (D)

COMBINATION OF COST - VOLUME &


REVENUE VOLUME RELATIONSHIP
C
o
s
t

or

R
e
v
e
n
u
e

Represents the
Maximum Profit
Total Cost

a vc
2b

D*

Volume (D)

Demand that maximizes


Total Profit

Formulas:
Price:

p a bD

Total Revenue:

TR pD
TR (a bD) D
or
TR aD bD 2

Total Cost : TC TVC TFC

TC vcD TFC

Profit: P TR TC

P pD (vcD TFC )
P (a bD) D vcD TFC
P bD 2 ( a vc) D TFC

a
D
2b

Demand that maximizes Revenue

Demand that maximizes Profit


(Optimum Profit)

a vc
2b

Break even points: Profit = 0


P TR TC
P pD (vcD TFC )
P (a bD) D vcD TFC
P bD 2 (a vc) D TFC
0 bD 2 (a vc) D TFC
2

(
a

vc
)

(
a

vc
)
4(b)(TFC )
'
D
2(b)

COST CONCEPTS

I.

B:

Price is not constant

Break even point:


C
O
S
T

R
e
or v
e
n
u
e

TFC
D
p vc
'

D'

TFC
p vc

IT
F
O
PR

Break Even Point


where TR=TC
ss
o
L

Volume (D)

Examples:
1. A company produces circuit boards to update the
outdated computer equipment. The fixed cost is $42,000
per month and the variable cost is $53 per circuit board.
The selling price per unit is p = $150 0.02D. Maximum
output of the plant is 4000 units per month.
(a) Determine the optimum value for this product.
(b) What is the maximum profit per month?
(c) At what volumes does break-even occur?
(d) What is the companys range of profitable demand?

Examples
2. A large semiconductor plant has approximately 95% of sales
due to a single circuit design. The plant can therefore be
considered to produce 3,000,000 printed circuit boards (PCBs)
per year. Presently, the plant is operating at 60% of capacity.
The selling price of the PCB is p = $19.25 (10- 6 )D, and the
variable cost per PCB is $15.75. At zero output, the plants
annual fixed costs are $1,000,000 and are approximately
constant up to the maximum production quantity per year.
a. What is the present expected annual profit or loss (60%
capacity)?
b. What the percentage of production capacity that will result in
optimal operation? What is the maximum profit or minimum loss
at this optimal volume?
b.Determine at what demand(s) breakeven occurs in the
operation

Examples:
3.A manufacturing company leases for $100,000 per year a
building that houses its manufacturing facilities. In
addition, the machinery in the building is being paid for
installments of $20,000 per year. Each unit of product
produced costs $15 in labor and $10 in materials and can
be sold for $40.
a.How many units per year must be sold for the company
to break even?
b. If 10,000 units per year are sold, what is the annual
profit?
c. If the selling price is lowered to $35 per unit, how many
units must be sold each year for the company to earn a
profit of $60,000 per year?

4.A company produces and sells a consumer product and thus


far has been able to control the volume of the product by
varying the selling price. The company is seeking to maximize
its net prot. It has been concluded that the relationship
between price and demand, per month, is approximately
where p is the
price
unit in dollars. The xed cost is
D = 500
5 pper
,
$1,000 per month, and the variable cost is $20 per unit.
Obtain the answer mathematically to the following questions:
a. What is demand that will maximize revenue per month
and the maximum revenue
b. What is the optimal number of units that should be
produced and sold per month?
c. What is the maximum prot per month?
d. What are the breakeven sales quantities and the range
of protable demand (volume)?

5. A plant operation has fixed cost of $2,000,000 per


year, and its output capacity is 100,000 electrical
appliances per year. The variable cost is $40 per unit,
and the product sells for $90 per unit.
a) What is the annual break even volume of this
product?
b) Compare annual profit when the plant is operating at
90% capacity with the plant operation at 100%
capacity. Assume that the first 90% of capacity output
is sold at $90 per unit and that the remaining 10% of
production is sold at $70 per unit.

Examples
6.
A company has established that the relationship
between the sales price for one of its products and
the quantity sold per month is approximately D = 780
10p units. The fixed cost is $800 per month, and
the variable cost is $30 per unit produced. What
number of units should be produced per month and
sold to maximize net profit? What is the maximum
profit per month? Determine the range of profitable
demand.

Examples:
7. The annual fixed costs for a plant are P100,000
and the variable costs are P140,000 at
70%utilization of available capacity with net sales
of P280,000. What is the break even point in units
of production if the selling price per unit is P40.

8. Suppose we know that p=1,000 D/5, where p =


price in dollars and D = annual demand. The total
cost per year can be approximated by $1,000 + 2D2 .
a. Determine the value of D that maximizes profit.
b. Show that in part(a) profit has been maximized rather
than minimized.

Answer:
(a)
p = 1,000 - 0.2D
TC = 1,000 + 2D2
Profit

= Total Revenue - Total Cost


= (1,000 - 0.2D)D - (1,000 + 2D2)
= 1,000D - 2.2D2 - 1,000
d Profit
= 1,000 - 4.4 D* = 0
dD

D*
(b)
D*.

= 227.27 units per year

d 2 (Profit)
= - 4.4 < 0
2
dD

Since the second derivative is negative, profit has been maximized at

6. The fixed cost for a steam line per meter of pipe is

$450X + $50 per year. The cost for loss of heat from
the pipe per meter is $4.8/X1/2 per year. Here X
represents the thickness of insulation in meters and
X is a continuous design variable.
a. What is the optimum thickness of the insulation?
b. How do you know that your answer in (a)
minimizes total cost per year?

Answer:
(a) Total Annual Cost (TAC) = Fixed cost + Cost of Heat Loss
= 450X + 50 +

4.80
X1/ 2

d (TAC)
2.40
= 0 = 450 - 3/2
dX
X

3/2

2.40
=
= 0.00533
450

X* = 0.0305
meters
2
d (TAC) for X >3.6
(b)
0. > 0
=
2
5/ 2

dX

Since the second derivative is positive, X * = 0.0305 meters is a minimum cost thickness.
(c) The cost of the extra insulation (a directly varying cost) is being traded-off against the
value of reduction in lost heat (an indirectly varying cost).

7. A local defense contractor is considering the


production of fireworks as a way to reduce
dependence on the military. The variable cost per unit
is $40D. The fixed cost that can be allocated to the
production of fireworks is negligible. The price
changed per unit will be determined by the equation
p=$180-(5)D, where D represents demand in units
sold per week.
a. What is the optimum number of units the defense
contractor should produce in order to maximize profit
per week?
b. What is the profit if the optimum number of units are
produced?

(a) Total Revenue = p D


= (180 5D)D = 180D 5D2
Total Cost = (40D)D = 40D2
Total Profit = -5D2 + 180D 40D2
d (Profit)
dD

= - 10D + 180 80D = 0;


90D = 180; D* 2 units/week
d 2 (Profit)
dD 2

= -90 < 0 maximum profit


(b)

Total Profit = -5(22) + 180(2) 40(22)


= -20 + 360 160 = $180 / week

Seatwork:
1. A company has determined that the price and that

monthly demand of one of its products are related by


the equation
D (400 p )

The associated fixed costs are $1,125/month, and the


variable costs are $100/unit.
a. What is the optimal number of units to maximize
revenue and the maximum revenue?
b. What is the optimal number of units that should be
produced and sold each month to maximize profit?
c. What are the break even points?

2. A plant operation has fixed cost of $2,000,000 per


year, and its output capacity is 100,000 electrical
appliances per year. The variable cost is $40 per unit,
and the product sells for $90 per unit.
a) What is the annual break even volume of this
product?
b) Compare annual profit when the plant is operating
at 90% capacity with the plant operation at 100%
capacity. Assume that the first 90% of capacity output
is sold at $90 per unit and that the remaining 10% of
production is sold at $70 per unit.

3. A manufacturer is currently selling 1000 decorative lamps


a month to the retailers at a price of P800 per lamp. Its
estimates that for each P50 increase in the price will sell
20 fewer lamps each month. The manufacturers cost
consists of a fixed overhead of P300,000/ month plus
P300 per lamp for labor and materials.
a. Set up the total cost function
b. Set up the demand function
c. Find the Break Even points
d. Find the volume that will maximize profit
e. What is the maximum profit?
f. What is the volume of sales that will maximize your sales
revenue?

4. Bragg & Stratton Company manufactures a specialized


motor for chain saws. The company expects to manufacture
and sell 30,000 motors in year 2001. It can manufacture an
additional 10,000 motors without adding new machinery
and equipment. Its projected total costs for the 30,000 units
are as follows:
Direct Materials
$150,000
Direct Labor
100,000
Manufacturing Overhead:
Variable Portion
100,000
Fixed Portion
80,000
Selling and Administrative costs:
Variable Portion
180,000
Fixed Portion
70,000
The selling price for the motor is $80.
a. What is the total manufacturing cost per unit if 300,000
motors are produced?
b. What is the total manufacturing cost per unit if 40,000
motors are produced?
c. What is the break even price on the motors?

d (TR)
dD

88.5
(0.08)(1.75)

88.5

(0.08)(1.75)

d (TP)
dD

48.5

(0.08)(1.75)

48.5
(0.08)(1.75)

(c)
FC = [$350,000 - 0.1($350,000)](12) =
$3,780,000 per year (10% decrease)
vc = [$0.50 + 0.1 ($0.50)] = $0.55 per unit of
sales (10% increase)
$3,780,000
D =
= $8,400,000 per year
$1 - $0.55

Thus, no change occurred in the original


breakeven point.

2-20

(a) D =

CF
$2,000,000
=
= 40,000 units per year
p - cv
($90 - $40) / unit

(b) Profit(Loss) = Total Revenue - Total Cost


(90% Capacity)
= 90,000 ($90) - [$2,000,000 +
90,000 ($40)]
= $2,500,000 per year
(100% Capacity) = [90,000($90) + 10,000($70)] [$2,000,000 + 100,000($40)]
= $2,800,000 per year

BREAK EVEN ANALYSIS, TWO ALTERNATIVES


Industry is faced with certain situations where two or more alternatives can be
considered. When the cost for two alternatives is affected by a common decision
variable, there may exist a value of the variable for which the two alternatives will
incur equal cost. This value is known as the break-even cost. Below this cost, one
method will be more economical, and above this cost, the other will prove to be
better economically.
TCA
TCB
Total Cost

D
TCA = TCB

Volume (D)

Examples
1. Two manufacturing methods are being
considered. Method A has a fixed cost of
P5,000 and a variable cost of P50. Method B
has a fixed cost of P2500 and a variable cost of
150. For what production volume would one
prefer (a) Method A, and (b) Method B?

2.

Two companies are engaged in the manufacture of shirts.


Company A, using mostly handwork, has a fixed cost monthly
expense of P45,000 and a variable cost of P15.00 per shirt.
Company B has been able to mechanize most of its
operations, and it finds its fixed monthly expenses are
P80,000 and the variable cost per shirt is P12.50.
a.
How many shirts should be manufactured by each
month so that the total cost will be the same for the two
companies?
b.
If each shirt sells for P32.00 to the retailers,
determine the monthly gross profit for each company.

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